Industrial real estate and inflation

Inflation is on the tip of everyone’s tongue right now. ANZ Bank now expects annual headline inflation to peak at 7.4% in the second quarter of 2022 (Source RNZ). As a small open economy, New Zealand is exposed to global fluctuations in commodity prices. I can confidently say that you have probably noticed this at the supermarket and petrol pump lately!

A common question investors have been asking lately is, “how does the current inflationary environment affect industrial real estate?”

Firstly, let's define inflation. Inflation can be summarised as the decline of the purchasing power of a given currency over time. In an inflationary environment, the general price of goods and services increases, meaning that one dollar effectively buys less than it did in prior periods. This loss of purchasing power impacts the cost of living. In New Zealand, the most commonly used inflation index is the Consumer Price Index (CPI).

During periods of high inflation, investors often look to increase the allocation of tangible assets in their portfolio. Industrial real estate is one of these tangible assets and is often viewed as an effective inflation hedge, this article will help you understand why.

Industrial leases are typically structured to keep pace with inflation

Lease agreements in industrial real estate are typically structured in a way that increases the rental rate at regular intervals throughout the term, in fact, some leases have automatic CPI adjustments built-in. A typical example would be for the lease to call for an increase in the rent at a fixed rate of 1-3% annually or a variable rate of CPI +1-2%. This increase in rental income creates stable and growing cash flows that may keep pace with inflation. It is important to note that when underlying market rents rise, it normally takes some time for this to be realised in improved cash flows (depending on the frequency and nature of the rent review mechanisms).

Rising labour and material costs are limiting the supply of new construction

Construction cost inflation, industry capacity constraints, and shortages of materials are putting further pressure on the supply of new industrial stock and the market's ability to meet rising demand in the sector. This has created a supply/demand imbalance that continues to suppress vacancy rates and is ultimately a driver for rental growth and industrial property values. Replacement cost is also a key investment consideration. It helps measure the underlying value of an asset; increasing new-build costs improves the inherent value of existing supply, which further generates upwards pressure on pricing.

E-commerce adoption is driving huge demand for industrial space in Auckland

E-commerce adoption continues to be a significant tailwind for the industrial sector. JLL's latest market report shows strong activity from third-party logistics, food logistics, manufacturing firms and health-related organisations in the industrial leasing market. Vacancy rates for Auckland industrial property now sit at 1.9% (Source Colliers), an all-time low. This surging demand combined with a severe lack of supply (discussed above) has created a significant imbalance in the supply and demand dynamics of the Auckland industrial property market, driving increases in industrial rents and property values.

Summary

Industrial property has investment attributes that may prove helpful in an inflationary environment. This is because the rising cost of new construction limits supply, and many leases have rental review clauses that are tied to the CPI. Auckland-based industrial property, in particular, has its unique advantages due to a limited amount of industrial zoned land and heavy demand for space, driving vacancy rates down to historically low levels.

If you are interested to learn how Jasper can provide you with access to institutional-grade industrial real estate, please reach out to us at [email protected].